Call for Evidence on Derivatives

We set out two conditions for support: first, that there must be a concise and durable definition in legislation of what constitutes a “simple” derivative, and second that there should be a cap on the gross volume of derivatives which a ring-fenced bank can have on its balance sheet. [1]

In our Second Report, the Commission committed to consider the draft secondary legislation to satisfy ourselves as to whether these conditions are adequately met. [2]

On Thursday 7 March the Government issued a draft of the Financial Services and Markets Act 2000 (Excluded Activities and Prohibitions) Order, including proposed provisions which set out the conditions under which ring-fenced banks will be able to sell derivative products to customers. [3]

The Commission invites written responses on whether the draft secondary legislation relating to the provision of derivatives by ring-fenced banks adequately addresses the concerns raised in our First Report. The Commission requests responses to this call for evidence by Wednesday 27 March.

In particular, the Commission asks respondents to consider the questions below:

Article 4(1)(a) of the draft of the Order proposes to restrict the sale of derivatives to transactions where the “sole or main purpose” is to enable a customer to limit the extent to which “its business may be adversely affected by changes in interest or exchange rates or changes in commodity prices”.

1) Is it appropriate for SMEs to be able to hedge risks arising from price fluctuations directly with a ring-fenced bank, rather than with a non-ring-fenced bank, and if so, why?

2) Is it appropriate to permit ring-fenced banks to sell derivatives to customers when the “main” purpose is to hedge risks, rather than simply when the “sole” purpose is to do so?

3) What challenges is the PRA likely to face in defining rules to assess the purpose of derivative transactions and does the draft secondary legislation provide a clear enough mandate to support such rules?

Article 4(2)(a) of the draft of the Order proposes to restrict the sale of derivatives to those which fall within Section BIPRU 7.10.21(1) of the FSA Handbook, namely “linear products, which comprise securities with linear pay-offs (e.g. bonds and equities) and derivative products which have linear pay-offs in the underlying risk factor (e.g. interest rate swaps, FRAs, total return swaps)”. [4]

4) Is a restriction based on BIPRU 7.10.21(1) appropriate for limiting the provision of derivatives to simple products which serve the majority of SME needs? 

Article 4(2)(b) of the draft of the Order proposes to require that derivatives can be sold to customers only if there is evidence available to assess the fair value of the investment concerned in accordance with IFRS 13 and that evidence would be considered to constitute a level 1 or a level 2 input within the meaning of IFRS 13.

5) What will be the effects of the restrictions relating to evidence of the fair value of the investment, and how does will it help address the Commission’s concerns?

Article 4(3)(b) of the draft of the Order proposes a methodology for setting a gross cap on the total volume of derivatives sold to clients.

6) Is the proposed methodology for calculating a gross cap on the total of derivatives sold the appropriate one, and is it resistant to gaming?

Please note

Each submission should:

• clearly state at  the top which individual’s or organisation’s views the submission represents (which may be different from the particular person who sends it); 
• begin with a short summary in bullet point form; 
• have numbered paragraphs; and 
• be in Word format with as little use of colour or logos as possible.

A copy of the submission should be sent by e-mail to bankingstandards@parliament.uk and marked “Banking Reform Bill - Derivatives”.  There is no need to send a hardcopy.

It would be helpful, for Data Protection purposes, if individuals submitting  written evidence send their contact details separately in a covering letter. You should be aware that there may be circumstances in which the Commission will be required to communicate information to third parties on request, in order to comply with its obligations under the Freedom of Information Act 2000.

A guide for written submissions to Select Committees may be found on the parliamentary website:

• Guide for Witnesses to House of Commons Select Committees

Please also note that:

• Material already published elsewhere should not form the basis of a submission, but may be referred to within a proposed memorandum, in which case a hard copy of the published work should be included.
• Memoranda submitted must be kept confidential until published by the Commission, unless publication by the person or organization submitting it is specifically authorised.
• Once submitted, evidence is the property of the Commission. The Commission will normally, though not always, choose to make public the written evidence it receives, by publishing it on the internet (where it will be searchable), by printing it or by making it available through the Parliamentary Archives.  If there is any information you believe to be sensitive you should highlight it and explain what harm you believe would result from its disclosure. The Commission will take this into account in deciding whether to publish or further disclose the evidence.

Notes

[1] First Report, paragraphs 191-195
[2] Second Report - Banking reform: towards the right structure, paragraph 41
[3] Financial Services and Markets Act 2000 (Excluded Activities and Prohibitions) Order
[4] http://fsahandbook.info/FSA/html/handbook/BIPRU/7/10